Government Officials Say Sweeping Financial Overhaul Is Coming

New financial regulations could make things worse if Congress isn't careful

In the coming weeks the movement to reorganize the U.S. financial industry will begin to pick up steam. Federal Reserve Chairman Ben Bernanke is urging a sweeping overhaul of financial regulation.

Lawmakers are wrestling through legislative options in an effort to remake the regulatory system that is being blamed by many for the current recession. While absolutely true that financial sector regulations are out of date and problematic in many ways, the restructuring process could cause even more damage if it’s not done properly.

Some regulation is not necessarily a bad thing, but getting it right takes a lot of work. Broadly speaking, regulation is intended to provide a common set of standards-rules of the game-for market activity and to prevent information asymmetry where a few people have significantly better information than the average investor. Regulations must govern against harmful business practices, but shouldn’t overburden the wealth creation process.

The free market critique of many regulations is that they usually result in a host of unintended consequences, creating perverse incentives that distort decision-making, and unnecessarily restrict business activity. The mark-to-market regulations that rigidly priced assets below their long-term values during the meltdown last fall are a perfect example of a well-intended but harmful regulation practice.

Mark-to-market laws were intended to prevent fraud by creating a standard accounting method for determining the value of financial assets. However, these regulations forced assets that temporarily lost value in September to be priced below what their long-term worth really was. This in turn destroyed bank balance sheets and was the direct cause of firms such as Lehman Brothers and Washington Mutual failing.

In order to avoid similar unintended consequences, there are three things the White House, Federal Reserve, Congress and others should bear in mind as they lay the groundwork for updating the financial regulatory system.

First, regulators should make sure they are identifying and addressing the root problems. Consider the complaints about short selling. This practice, essentially betting that a company is going to do poorly instead of betting that they will do well, has been cited as a cause for many major stock collapses. The theory is that if several people start betting against a particular stock, this can cause a panic, leading to a massive selloff of that stock. In such a case, the short sellers make money, and the firm loses capital.

The question is, should regulators ban or limit short selling in the regulatory overhaul? The reality is that short selling serves a good purpose. Massive short selling of a stock may accurately signal a problem with the firm. It would be foolish to regulate this knowledge sharing process out of the system.

Some believe that traders who short sell stocks spread false rumors that a firm is doing poorly in order to get people to sell the stock. But when this happens it is an exception, not a systemic problem.

“The ban on short-selling may prolong the crisis in the sense that it will now take the markets longer to adjust to the true values of financial companies,” Adam Reed, a finance professor at the University of North Carolina at Chapel Hill, told The New York Times.

Second, when redesigning regulations to avoid future cascading meltdowns, lawmakers should design laws that require firms to be responsible for their market activity. In simple terms: require companies to have some skin in the game. One problem that developed over the past several years is that companies on Wall Street began to act as if they had some implicit safety net. Capital reserve ratios swung heavily towards debt-banks were leveraged as much as 30 to 1-leaving many scrambling when asset values rapidly dropped.

This might mean revisiting capital reserve requirements, but it absolutely means the government should clarify its position relative to these firms. The Fed, FDIC, Treasury, and rest of the government should explicitly state that they will not be responsible for future failures, and that companies should keep this in mind when making investments.

The costly failures of Fannie Mae and Freddie Mac are examples of what happens when government-sponsored enterprises, or any large firms, believe they can draw on taxpayer funds as an investment safety net.

If a company does not have the capacity to orderly enter bankruptcy proceedings at any given moment, then they must be depending on something else, like taxpayers, to save them-or they are defrauding their investors.

Third, the government should ensure that its newly adjusted regulatory system does not restrict entrepreneurial activity.

The Group of Thirty, an influential group of financial leaders and academics, released a financial overhaul plan with 18 recommendations in January. Chaired by former Federal Reserve chairman Paul Volker, the plan recommends restricting banks from engaging in investment activity, thereby dividing up deposit bearing institutions and private-equity firms. Such a move would virtually reinstate the Glass-Steagall Act regulations that kept commercial and investment banks separate for nearly 70 years.

The repeal of Glass-Steagall in 1999 created an era of unprecedented growth in the financial sector. It allowed for the emergence of firms like Bank of America and Citigroup. But those banks overleveraged themselves and have now fallen. The problem was not that successful banks were too mixed up with investing; they simply failed to adequately manage their risk. And instead of being punished by the market, they are being bailed out by taxpayers.

Under current law, banks can leverage deposits into investments, providing capital to business ventures. Restricting commercial banks from engaging in this investment activity would dramatically reduce the flow of capital to private equity and limit entrepreneurial activity.

Better regulation would concentrate on setting reserve requirements for big firms so that they are not allowed to become “too big to fail.”

The reality is that economic analysts and financial experts are fallible, whether they work on Capitol Hill or in the Financial District. Imagine if after the Dot-Com bubble burst there had been a national movement to overhaul the financial sector’s regulations. The very same people we now demonize for their actions over the past few years would have been the people we asked to fix everything.

Simply put, lawmakers won’t be perfect in redesigning the regulatory system. While this doesn’t mean we shouldn’t try to fix regulatory problems, it does mean that we should recognize the limits of our ability to solve every problem and not excessively regulate, restrict, and handcuff the market.

Anthony Randazzo is a policy analyst at Reason Foundation.